How Do We Measure The Rate Of

Return On An Investment ?

The pure rate of interest is the

exchange rate between future
consumption (future dollars) and
present consumption (current
dollars). Market forces determine
this rate.
$1.00  4% $1.04
How Do We Measure The Rate Of
Return On An Investment ?

People’s willingness to pay the

difference for borrowing today and
their desire to receive a surplus on
their savings give rise to an interest
rate referred to as the pure time
value of money.
How Do We Measure The Rate Of
Return On An Investment ?
If the future payment will be
diminished in value because of
inflation, then the investor will
demand an interest rate higher
than the pure time value of money
to also cover the expected inflation
expense.
How Do We Measure The Rate Of
Return On An Investment ?

If the future payment from the

investment is not certain, the investor
will demand an interest rate that
exceeds the pure time value of
money plus the inflation rate to
provide a risk premium to cover the
investment risk.
Defining an Investment

A current commitment of $ for a

period of time in order to derive
future payments that will
compensate for:
– the time the funds are committed
– the expected rate of inflation
– uncertainty of future flow of funds.
Measures of
Historical Rates of Return
Holding Period Return

Ending Value of Investment

HPR 
Beginning Value of Investment
$220
  1.10
$200
Measures of
Historical Rates of Return

Holding Period Yield

HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
Measures of
Historical Rates of Return

Annual Holding Period Return

– Annual HPR = HPR 1/n
where n = number of years investment is held

Annual Holding Period Yield

– Annual HPY = Annual HPR - 1
Measures of
Historical Rates of Return 1.4

Arithmetic Mean
AM  HPY/ n
where :

 HPY the sum of annual

holding period yields
Measures of
Historical Rates of Return

Geometric Mean
GM  HPR 
1
n 1
where :
 the product of the annual
holding period returns as follows :
HPR 1 HPR 2  HPR n 
A Portfolio of Investments

The mean historical rate of return

for a portfolio of investments is
measured as the weighted average
of the HPYs for the individual
investments in the portfolio, or the
overall change in the value of the
original portfolio
Computation of Holding
Period Yield for a Portfolio

# Begin Beginning Ending Ending Market Wtd.

Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 0.010
B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 0.010
C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 0.075
Total $ 20,000,000 $ 21,900,000 0.095

$ 21,900,000
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%
Expected Rates of Return

Risk is uncertainty that an

investment will earn its expected
rate of return
Probability is the likelihood of an
outcome
Expected Rates of Return

Expected Return E(R i )

n

 (Probabilit y of Return) (Possible

i 1
Return)

[(P1 )(R 1 )  (P2 )(R 2 )  ....  (Pn R n )

n

 (P )(R
i 1
i i )
Risk Aversion

The assumption that most investors

will choose the least risky
alternative, all else being equal and
that they will not accept additional
risk unless they are compensated in
the form of higher return
Probability Distributions
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
 Probability Distributions
Risky Investment with 3 Possible Returns

1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
Probability Distributions
Risky investment with ten possible rates of return

1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
Measuring the Risk of
Expected Rates of Return

Variance ( ) 
n

 (Probabilit
i 1
y) (Possible Return - Expected Return) 2

 (P )[R
i 1
i i  E(R i )] 2
Measuring the Risk of 1.8
Expected Rates of Return

Standard Deviation is the square

root of the variance
Measuring the Risk of
Expected Rates of Return

Coefficient of variation (CV) a measure of relative

variability that indicates risk per unit of return
Standard Deviation of Returns
Expected Rate of Returns

i

E(R)
Low Risk vs. High Risk Investments

1) Earns 10% per year for each of ten years (low

risk)
– Terminal value is $25,937
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, -
12%, and 10% in the ten years, respectively (high
risk)
– Terminal value is $23,642

 The lower the dispersion of returns, the greater the

terminal value of equal investments
Measuring the Risk of
Historical Rates of Return
n
 2
 [ HPYi  E ( HPY) 2/n

i 1
  variance of the series
2

HPYi  holding period yield during period I

E(HPY)  expected value of the HPY that is equal to
the arithmetic mean of the series

n  the number of observations

Determinants of
Required Rates of Return

Time value of money during the

period of investment
Expected rate of inflation during the
period
Risk involved
The Real Risk Free Rate (RRFR)

– Assumes no inflation.
– Assumes no uncertainty about future
cash flows.
– Influenced by time preference for
consumption of income and
investment opportunities in the
economy
Adjusting For Inflation

Real RFR =

 (1  Nominal RFR) 
 (1  Rate of Inflation)   1
 
Nominal Risk-Free Rate

Dependent upon
– Conditions in the Capital Markets
– Expected Rate of Inflation
Adjusting For Inflation

Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
Debt
Tax Shield Benefit Depends on the
Corporate Tax Rate

 Small businesses in Canada face a corporate tax rate

in the range of 20%.
 Smaller businesses are riskier than larger businesses
so they borrow at higher rates.
 If a small business borrows at 200 basis points above
prime, and prime is 5.00%, the cost of debt is 5% +
2% = 7%
 The after-tax cost of debt for the smaller business is
therefore:
K K d (1  T ) 7% (1 - .2) 5.6%
Debt
Tax Shield Benefit Depends on the Corporate
Tax Rate

 Large corporations in Canada face a corporate tax rate in

the range of 34%.
 If the corporation borrows at 25 basis points above prime,
and prime is 5.00%, the cost of debt is 5% + .25% = 5.25%
 The after-tax cost of debt for the corporation is therefore:

 Given the very low after-tax cost of debt, corporations and individuals
who face high
K marginal
K d (1  Ttax
) rates,
5.25% have
(1 a strong
- .34) inducement to finance
3.465%
their profit-seeking activities through the use of debt.
Short-Term Debt and the Money Market
Government Treasury Bill Yields

Government of India
Treasury Bills are sold at a
discount from their face P P 
T - bill Yield  1 0  
365
value.  P0  number of days to maturity
 The difference between the  $100  $99.0909   365 
price paid and the face value   
is treated as interest.  $99 .0909   91 
 Prices are quoted on the 0.0091744054.010989011
basis of a Rs100 par value to 3.7%
four significant digits.
 Bills are normally purchased
in denominations of
Rs100,000 and greater.

Example:
A 91-day T-bill is sold for a
price of Rs 99.0909 for a par
value of Rs100.
Facets of Fundamental Risk

Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
Business Risk

Uncertainty of income flows

caused by the nature of a firm’s
business
Sales volatility and operating
leverage determine the level of
business risk.
Financial Risk

 Uncertainty caused by the use of debt

financing.
 Borrowing requires fixed payments which
must be paid ahead of payments to
stockholders.
 The use of debt increases uncertainty of
stockholder income and causes an increase
in the stock’s risk premium.
Liquidity Risk

 Uncertainty
is introduced by the
secondary market for an investment.
– How long will it take to convert an
investment into cash?
– How certain is the price that will be
received?
Exchange Rate Risk

 Uncertainty of return is introduced by

acquiring securities denominated in a
currency different from that of the
investor.
 Changes in exchange rates affect the
investors return when converting an
investment back into the “home”
currency.
Country Risk

 Political risk is the uncertainty of returns

caused by the possibility of a major change in
the political or economic environment in a
country.
 Individuals who invest in countries that have
unstable political-economic systems must
include a country risk-premium when
determining their required rate of return
Risk Premium

f (Business Risk, Financial Risk,

Liquidity Risk, Exchange Rate
Risk, Country Risk)
or
f (Systematic Market Risk)
Risk Premium
and Portfolio Theory
 The relevant risk measure for an
individual asset is its co-movement with
the market portfolio
 Systematic risk relates the variance of
the investment to the variance of the
market
 Beta measures this systematic risk of
an asset
Fundamental Risk
versus Systematic Risk

• Fundamental risk comprises business

risk, financial risk, liquidity risk,
exchange rate risk, and country risk
• Systematic risk refers to the portion of
an individual asset’s total variance
attributable to the variability of the total
market portfolio
 Relationship Between
Risk and Return

(
E
x
p Rateof Return
e Low Average High
Security
Market Line
Risk Risk Risk
c
t
e The slope indicates the
required return per unit of risk
RFR
d
Risk
) (business risk, etc., or systematic risk-beta)
Changes in the Required Rate of Return
Due to Movements Along the SML

Expected
Rate
Security
Market Line

Movements along the curve

that reflect changes in the
RFR risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
Changes in the Slope of the SML

RPi = E(Ri) - NRFR

where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free
asset
 1.14
Market Portfolio Risk

The market risk premium for the market

portfolio (contains all the risky assets in the
market) can be computed:
RPm = E(Rm)- NRFR where:
RPm = risk premium on the market portfolio
E(Rm) = expected return on the market portfolio
NRFR = Expected Nominal Return on a risk-free
asset
 Change in
Market Risk Premium

E(R) Return
Expected
New SML

Rm'
Rm´
Original SML
Rm
Rm

NRFR
RFR
Risk
 Capital Market Conditions,
Expected Inflation, and the SML

NE
Rx
Fp
Re
Rate of Return
´c
New SML
t
e Original SML
d RFR'

RFR
R
Risk
e
t
Equity Shares - classification
 Blue-chip shares – of large well established and
financially strong companies with impressive
record of earnings and paying
 Growth shares – Cos having fairly entrenched
position in growing market which enjoys above
average rate of growth as well as profitability
 Income shares – co’s having fairly stable
operations, relatively limited growth
opportunities and high dividend pay out ratio.
 Cyclical shares – pronounced cyclicity in their
operations
 Defensive shares – relatively unaffected by the
ups and downs in general business conditions
 Speculative shares – fluctuate widely because
there is lot of speculative trading in the company
 Foreign equities - by listing the share in foreign
market in their exchange rate ; through
GDR’’s/ADR- represent indirect ownership of
specific number of shares of a foreign company.
Issued by US banks called depositories. Thus
ADR’s are tradeable receipts issued by
depositories that have physical possession of
foreign securities through their foreign
correspondent banks.
Investment Objectives

Risk Tolerance
Absolute or relative percentage
return
General goals
Investment Objectives

General Goals
 Capital preservation
– minimize risk of real loss
 Capital appreciation
– Growth of the portfolio in real terms to meet future
need
 Current income
– Focus is in generating income rather than capital gains
Investment Objectives

General Goals
 Total return
– Increase portfolio value by capital gains and by
reinvesting current income
– Maintain moderate risk exposure
Investment Constraints

 Liquidity needs
– Vary between investors depending upon age,
employment, tax status, etc.
 Time horizon
– Influences liquidity needs and risk tolerance
Investment Constraints

 Tax concerns
– Capital gains or losses – taxed differently from income
– Unrealized capital gain – reflect price appreciation of
currently held assets that have not yet been sold
– Realized capital gain – when the asset has been sold at
a profit
– Trade-off between taxes and diversification – tax
consequences of selling company stock for
diversification purposes
Constructing the Policy Statement

 Objectives - risk and return

 Constraints - liquidity, time horizon, tax factors,
legal and regulatory constraints, and unique
needs and preferences
 Developing a plan depends on understanding
the relationship between risk and return and the
the importance of diversification
The Importance
of Asset Allocation

 Aninvestment strategy is based on four

decisions
– What asset classes to consider for investment
– What normal or policy weights to assign to each
eligible class
– Determining the allowable allocation ranges
based on policy weights
– What specific securities to purchase for the
portfolio
The Importance
of Asset Allocation

 According to research studies, most (85% to

95%) of the overall investment return is due
to the first two decisions, not the selection of
individual investments
Returns and Risk of Different Asset
Classes

 Historically, small company stocks have

generated the highest returns. But the volatility
of returns have been the highest too
 Inflation and taxes have a major impact on
returns
 Returns on Treasury Bills have barely kept pace
with inflation
Summary

• Identify investment needs, risk tolerance, and

familiarity with capital markets
• Identify objectives and constraints
• Enhance investment plans by accurate formulation
of a policy statement
• Focus on asset allocation as it determines long-
term returns and risk